August 06, 2014

Making Sense of Bitcoin Derivatives Regulation

Bitcoin price volatility isn't what it used to be. Compared to its meteoric rise and fall in 2013, recent months' fluctuations around $600 seem tame.

But despite the fact that Bitcoin has become boring--at least for speculators--widespread adoption of the cryptocurrency will not happen unless merchants and others can shield themselves from its volatility.

And companies are stepping up to meet that need.

A recent entry is Coinapult’s Locks, a service that allows customers to lock in the price of their bitcoins to an existing currency like dollars or Euros, and even gold. The Bitcoin Mercantile Exchange is another relative newcomer, and reportedly went live last week (on July 28, 2014).

Companies hedging fluctuations in currency prices is nothing new, of course. Firms that operate internationally routinely use derivatives contracts to reduce risk. Coca-Cola, for example, uses forwards and options to hedge currency price risk from selling in Europe and Japan.

So as companies increasingly offer derivatives to hedge Bitcoin price risk, an open question is how Bitcoin derivatives will be regulated. It's an open question because the Commodity Futures Trading Commission (CFTC) has yet to take any public action regarding Bitcoin derivatives even though they fall directly under the CFTC's jurisdiction.

Nonetheless, the CFTC's existing regulatory framework is clear enough to make sense of how Bitcoin derivatives are likely to be regulated. In broad terms, CFTC regulation has three components most relevant to the Bitcoin economy: futures regulation, the distinction between futures and forwards, and swaps regulation.

Futures

Futures contracts, whereby one party agrees to deliver an underlying asset or its cash-equivalent at a later time at a pre-specified price, fall squarely within the CFTC's jurisdiction. They're standarized with respect to all terms except for price and are required by law to trade on regulated futures exchanges.

Virtually any type of economic good or measurable quantity--from crops to prices to the weather--can be the basis of a futures contract. This is due to the Commodity Exchange Act's extremely broad definition of "commodity." When it comes to Bitcoin, the only question right now is whether the CFTC will categorize bitcoins as "excluded commodities" like currencies or other financial interests, or as "exempt commodities" like gold and other precious metals.

Futures Versus Forwards

In contrast to futures are forward contracts. Forward contracts also lock in a price for an underlying commodity at the inception of the contract. But unlike futures, forwards are not standardized, do not trade on exchanges, and physically deliver the underlying commodity. In the words of the CFTC, the “primary purpose of a forward contract is to transfer ownership of the commodity and not to transfer solely its price risk” as is the case with futures.

Importantly, forward contracts are not regulated by the CFTC.

While it may be obvious whether a particular contract is a future or a forward, when the CFTC or courts distinguish between the two, the most important factor tends to be whether the contract was intended to physically deliver a commodity (and hence is a forward) or whether it was meant to enable parties to speculate on the price of the commodity (and hence is a future). A contract is also more likely to be considered a forward if it is not fungible and not traded on a venue that functions as an exchange (by, for example, taking on counterparty risk and enabling parties to enter into offsetting contracts).

Whether a contract is a regulated Bitcoin futures or an unregulated Bitcoin forward in principle should be no different that futures and forward in other types of commodities. If the agreement is highly standardized and traded without the intent or ability of the parties to physically deliver Bitcoins, it may be deemed a futures agreement. Contracts that contemplate physically delivering bitcoins or that are nonfungible are likely to be considered forward and fall outside of CFTC regulation.

Importantly, the fact that bitcoins are digital assets and cannot be "physically" delivered in the traditional sense does not matter: the CFTC recognizes that intangible assets (which may include bitcoins) may be the subject of a forward contract so long as "ownership of the commodity can be conveyed in some manner and the commodity can be consumed.” Bitcoin ownership can certainly be conveyed and, if bitcoins are deemed by the CFTC to be intangible, spending or trading them likely qualifies as being "consumed."

Swaps

Swap agreements are another common way for companies to hedge price risk. In a swap, two parties agree to exchange cash or other another commodity based on the price of an underlying asset or event. Ford Motor Credit, for example, uses cross-currency swaps to reduce its exposure to exchange rate changes arising from international debt financing.

Due to reforms ushered in by the Dodd-Frank Act, swaps are subject to a fair amount of CFTC regulation. Swaps must be cleared and traded on regulated central counterparties and multi-dealer trading platforms. Dealers and major users of swaps are also subject to capital, disclosure, and a host of other regulations. Swaps that are not subject to mandatory clearing are still subject to margin requirements, which may be fairly onerous once they are finalized.

Users of Bitcoin swaps may be able to escape the full scope of swaps regulation, however. Merchants that use Bitcoin swaps to hedge price risk would like qualify for the commercial end-user exemption from mandatory swaps clearing. In addition, to the extent a Bitcoin derivatives contract is structured and recognized by the CFTC as a contract involving a nonfinancial commodity intended for physical delivery, it will be deemed a forward contract and by definition excluded from any aspect of swaps regulation.

Finally, there is also the possibility that the Treasury Department may ultimately end up exempting physically settled Bitcoin swaps from the clearing mandate for the same reasons it did so for certain physically settled foreign exchange swaps; namely, because they are short-dated and don't pose a systemic risk.

Options are another type of derivative that may help to reduce Bitcoin volatility. They are basically regulated like swaps.

While it is certainly possible that the CFTC will create a unique regulatory framework specifically for virtual currencies like Bitcoin, it is more likely that its existing framework for futures and swaps regulation already provides a basis for understanding how Bitcoin derivatives will be eventually regulated.

For a deeper analysis of Bitcoin financial regulation, see my co-authored article here.